How we got here: Bush economic advisor analyzes the financial sector meltdown

The deepest recession since World War II was caused by the collapse of the financial sector, but that disintegration is not proof that markets don't work, said Stanford economist Edward Lazear, who was chief economic advisor to former President George W. Bush. In fact, he said, the markets dealt swift and brutal punishment to those who made mistakes.

The deepest recession since World War II was caused by the collapse of the financial sector, but that disintegration is not proof that markets don't work, said Stanford economist Edward Lazear, who was chief economic advisor to former President George W. Bush. In fact, he said, the markets dealt swift and brutal punishment to those who made mistakes. No one expected the wreckage of last September, Lazear said — himself included.

Speaking at the Economic Club of Phoenix recently, Lazear recalled that toward the middle of September last year he was getting ready to wrap up his service to the president and return to his academic career at Stanford. He even gave notice on his Washington apartment. Six months earlier, in March 2008, Bear Stearns had faltered and was bailed out. It was a shock, Lazear said, but the system seemed to stabilize.

Then in a single week in September, Lehman Brothers went under, troubled Merrill was acquired by Bank of America, Fannie Mae and Freddie Mac went into receivership, and Wachovia and Washington Mutual were on the ropes. Lazear delayed his return to Stanford. No one anticipated how massive the wreckage would be, Lazear said. And there are plenty of candidates to blame, he said, all of whom could claim 80 percent of the responsibility.

Where did it start?

To explain the roots of the crises, Lazear reached back to a shift in net lending. Historically, the industrialized nations have been the net lender to the developing world, he said. He likened it to a parent lending money to a child in graduate school. But between 2000 and 2007, there was a shift, and the developing nations began lending to the industrialized nations.

"It was as if the poor graduate students and undergraduates were lending to their parents so that their parents could buy a fancier Lexus," he said, "and we — the United States — were the recipients of a lot of that money." So what did that do? It reduced the credit spreads — the difference between the rate paid on risky investments to the lower rate paid on risk-less investments.

In 2003 the spread was about 1,000 basis points, Lazear said, but by 2007, because of the flow of money into the country from China and the oil-producing nations, the rate had fallen to about 350. Suddenly it became cheap to borrow to invest in risky activities, he said. Cheap money fueled rapid growth in subprime lending — what Lazear called the "epicenter" of the financial crises.

Subprime lending — loans made to borrowers who do not qualify for prime loans — is not new, he pointed out. Subprime loans have been written since the 'nineties, quintupling between 1993 and 1998, when activity leveled off and dipped before going up more than 2.5 times by 2005. The easy loan money sloshing through the market fueled housing, Lazear said.

Housing starts crested at about 2.2 million in 2006 — higher than the historical average of 1.5 to 1.6 million per year. "When you're a half million or so above the average and you're there for a couple of years it's not unreasonable to think that the supply of houses might outstrip the demand for houses," Lazear said.

The resultant falling prices put downward pressure on the ability to finance — and especially refinance — loans. This is where the system broke apart. People had been taking out loans that neither they nor the lenders expected to be repaid, because everyone expected to re-finance. This, Lazear said, was fine as long as equity values were going up.

The opposite occurred and default rates started to climb. Next came the credit crunch, which started in August 2007. "It looked like we were going to get by that one," he said, but then every month brought another break up — alarming events like the March 2008 failure of Bear Stearns.

Still, through the summer it appeared that the system had lurched back to stability — until September. In a single week the failures, buy outs, bailouts and near misses cascaded through the news like so many asteroids: Lehman Brothers, Merrill Lynch, Fannie and Freddie, AIG, Wachovia, Washington Mutual. Lazear dropped plans for an immediate return to academe.

Hindsight: "It worked"

The four most important measures taken by the Bush administration to address the trouble in the financial sector, Lazear said, included action by the Federal Reserve to pump liquidity into the system, enactment of the Troubled Assets Relief Program ("admittedly clumsily handled"), use of the Exchange Stabilization Fund to help restore confidence in the banking system and guarantee of bank liabilities by the FDIC.

These measures worked, Lazear argued, even though unemployment numbers seem to tell a different story. The troubles really began, Lazear said, in March 2007, and until September 2008, unemployment hovered around the historical average. It was not until after the September '08 disasters and the Bush administration's first aid measures that unemployment spiked.

This is consistent with the typical pattern for recessions, Lazear argued: After recovery begins, unemployment continues to build until jobs finally catch up. The big difference between the Bush and the Obama administrations is spending, he said. This year, government will spend up to 26 percent of GDP compared to the historical average of 21 percent. This is a "huge expansion in government," Lazear said, done in the hopes of stimulating the economy.

Lazear said the Obama actions have produced results, but the effects have been "quite small." The growth rate in the economy in the first quarter was -6 percent, he said; second quarter was -.7 percent. Even though the economy was shrinking, there was a 5 point improvement. Lazear estimates, however, that about four points would have happened anyway in the normal course of recovery, which means that stimulus efforts produced about 1 point improvement.

"It's significant because we have only spent somewhere between $100 and $150 billion of the stimulus money," he said. "We've got a $787 billion bill out there, so what we've got going forward is a very large expansion in the size of government." Lazear added that he doesn't think deregulation was the largest trigger for the collapse.

He pointed to three major deregulatory decisions in the Clinton administration (the Community Reinvestment Act, the repeal of Glass Steagell, and the non-regulation of derivatives), and another three in the Bush administration (the net capital rule, changing HUD rules about Fannie Mae and Freddie Mac and the HUD policy change concerning the Federal Housing Administration).

The spike in subprime lending occurred eight years after the Clinton actions took effect, Lazear said, probably too long to be the root cause. And the Bush deregulatory actions took place after the spike began. These events may have exacerbated the problems, he said, but they were not the cause.

One of Lazear's predecessors on the Council of Economic Advisers was Joseph Stiglitz, who has commented recently that this recession proves that markets don't work, Lazear reported. To the contrary, he said, companies that made mistakes have paid high prices, and others have remade themselves because of pressure from the market.

"Markets work — they're not perfect and they make mistakes, but they are quite rapid in remedying the things that they do wrong," Lazear said. "My guess is that if we put in new regulations — and we very well may — we will regulate the mistakes we made in the past and not the unanticipated ones in the future."